Trading cryptocurrency can be both rewarding and soul destroying, especially considering the recent bloodbath in Bitcoin. Searching online for reasons as to the sharp decline in the BTC price yields fascinating results. “Hodlers,” investors, and speculators have come up with a multitude of factors that contributed to the crypto crash of 2018. Governments, regulators, whales, futures have all taken the blame for conspiring to crush the decentralized currency.

What if it was all a lot simpler than that? What if the recent 65% drop in BTC was merely the work of a few bad actors controlling a large segment of the market? Trying to make sense of Tether and its impact on the crypto marketplace will raise a lot of FUD (Fear, Uncertainty, and Doubt) on forums and social media if you wander down the wrong thread.

The Conundrum of Trading Crypto on Exchanges

Trading cryptocurrency requires a few steps; register with an exchange, open an account, download software and place your first order. To cash out of the trade and realize profits as fiat currency in a bank account, customers need to send the exchange identity documents and proof of address verifying their details, to satisfy KYC and AML laws.

Two types of exchanges operate in the crypto markets, those that offer cryptocurrency trading in USD pairs and settle client accounts in USD, and those that do not provide USD pairs and USD redemption on trades. Coinbase/GDAX, Kraken, and Gemini are examples of exchanges that meet the requirements of the financial regulations needed to trade and cash out customer accounts for USD.

Bitfinex, Bittrex, Poloniex, and Binance are examples of exchanges that do not settle in USD but allow withdrawals in cryptocurrencies such as USDT, ETH, and BTC. This circumvention strategy allows the exchanges to avoid the hassle of complying with regulatory laws while legally operating a cryptocurrency exchange.

What is Tether?

Tether launched in mid-2015 as a solution to two underlying problems in the cryptocurrency trading world. First, Tether solved the problem of trading and settling customer accounts in USD by the non-compliant exchanges. The second problem Tether cleared up was aimed at the traders themselves. In periods of high price volatility, traders can cash out their crypto balances into Tether to escape swift adverse price action. When traders feel confident to enter the market again, they may convert their Tethers to the cryptocurrency of their choice and begin trading.

The reason this “Stablecoin” business model works is that Tether Limited guarantee that it would peg the price of Tether to the dollar at a rate of 1:1. Tether enforce this peg with open market operations between the non-compliant exchanges. All cryptocurrency pairs available on these non-compliant exchanges trade against Tether (USDT) trading pairs and accounts are settled in USDT (Tether), not USD.

Blind faith in the fact that Tether Limited will redeem USDT for USD at a rate of 1:1 is what keeps bots and traders arbitraging USDT between exchanges, thereby balancing the peg with their trading operations. As long as the non-compliant exchanges can keep the USD/USDT peg at the guaranteed ratio, the price of Bitcoin and other cryptocurrency's will be equal in both USD and USDT.

Shady Start-up and the Bitfinex Connection

Tracing the history of Tether and Bitfinex leads to some suspicious activity and a connection between the companies that was previously denied by the company's founders.

2012 sees iFinex founded in Hong Kong to become the parent company for both Bitfinex and Tether. Bitfinex incorporates in Hong Kong during 2013 and is run by CEO Jan Ludovicus van der with the help of Phil Potter and CFO Giancarlo Devasini.

Potter and Devasini decided to establish Tether Limited in the British Virgin Islands, while publicly stating that Bitfinex and Tether are entirely separate entities. Tether began trading on February 25, 2015, however; USDT circulation and issuance experiences very little growth in 2015 and 2016.

The second half of 2017 was challenging for Tether and Bitfinex. The “Paradise Papers” were leaked on November 7, 2017, proving that Bitfinex and Tether are owned and operated by the same people.

Bitfinex Hacked

On August 2, 2016, the second-largest digital currency exchange heist in history took place as hackers stole nearly 120,000 Bitcoin, worth around $75 million. This event was the most significant crypto hack of an exchange since the infamous Mt. Gox fell in 2014. Bitfinex did not disclose the full details of the hack. However, BitGo, the security company responsible for signing off on all transactions, issues a statement saying its servers were not involved in any security breach or compromised in any way.

Tether Hacked

On November 19, 2017, theiFinex group experiences its second hack as cyberthieves get away with 31 million USDT. Hackers breached the security of the Tether treasury wallet, sending the bitcoin to an unauthorized wallet address. To quarantine the funds from being spent by the thieves, Tether initiates a hard fork to the Omni chain.

Bitfinex Accused of Manipulation Tactics

As if two hacks and a sensitive document leak wasn't enough bad news for Tether and Bitfinex, in August of 2017 a Twitter user named @bitfinexed begins to blog. The blogs start to expose price manipulation tactics used by Bitfinex and Tether to move the Bitcoin market in the desired direction. The first blog introduced “Spoofy” a trading bot similar to the “Willy” bot that manipulated prices on the Mt. Gox exchange before its failure.

The @bitfinexed Twitter account and Medium blog collected an impressive amount of evidence against Bitfinex that included manipulation strategies such as “Quote Stuffing,” “Flash Orders,” “Wash Trading,” “Spoofing,” “Painting the Tape,” “Front Running,” and even trading against their own book.

Recent allegations against tether have suggested that they do not have the USD reserves to back the USDT held in their reserves and circulating through the crypto marketplace. If this is the case, then Bitfinex have created a money printer in Tether Limited that allows them to purchase Bitcoin with free money.

Bitfinex allegedly buys up the Bitcoin with freshly printed Tethers that are not backed by any USD and then proceeds to dump the BTC on real USD exchanges. Should this fraud be proven to be true, then Bitfinex and Tether would be at the center of one of the biggest financial scams in history.

The Audit That Never Was

When Tether Limited launched, they announced that they would be undertaking an annual audit of their finances. The nature of the audit was to provide transparency to their clients and the market, creating confidence around USDT and its legitimacy. It was not long afterward that Bitfinex experienced the second most extensive hack of all time with hackers stealing $75 million worth of BTC.

On August 17, 2016, Bitfinex announced that it had contracted a blockchain forensic firm, Ledger Labs, to investigate the hack as well as conduct a financial audit of its USD and USDT assets. After months with no update on the audit or the theft, Bitfinex states that it had never contracted Ledger Labs to conduct an audit.

Over the following year, Bitfinex loses Wells Fargo as their last tie to the international banking system in the United States. Shortly after that, Bitfinex also has their Taiwanese banking accounts closed, and they are forced to take deposits through shell company bank accounts incorporated in the BVI and other tax havens.

There was no further mention of an audit until Bitfinex engages Friedman LLP to audit their balance sheet on May 5, 2017. The 2017 bull run in Bitcoin takes off around this time as prices accelerate to new all-time highs on announcements of Japans acceptance of Bitcoin as legal tender.

At the peak of the Bitcoin bubble mania on December 2, 2017, Bitfinex announces in a quarterly report that it will stop serving U.S. customers. The move starts an investigation by the SEC and CFTC into price manipulation, and fraudulent ICO's, resulting in a subpoena served on Bitfinex on December 6, 2017. This news was kept from public knowledge and did not have any effect on the popping of the Bitcoin bubble only two weeks later.

In a shock move, Freidman LLP withdraws from the Tether audit on January 27, 2018. They remove all mention of the Bitfinex audit from their website and make a public statement that says they are unable to complete the audit. Tether has since not attempted to engage other auditors in the big four group of accounting firms.

While all of these facts do seem scandalous, there is no physical proof of these allegations at the time of this writing in mid-February 2018. Those that have chosen to question Bitfinex and Tether, such as the @bitfinexed account, experience ad hominem attacks from the Bitfinex PR team and network partners. It appears that Tether and Bitfinex will continue to side-step the audit and blame technical difficulties related to the nature of the crypto business for the delay.

Tethers Market Impact

Those that are aware of the Bitfinex and Tether scandal often state that Tethers portion of the total crypto market cap is only a drop in the bucket. This statement is true since all 2.3 billion of USDT printed represent about 0.6% of the total crypto market value. This small portion of the crypto ecosystem could not therefore possibly have any impact on asset pricing should it be proven to be a fraud.

This thesis does not take into account the trading volume, liquidity, and trading velocity of the USDT supply. Tether is the third most traded cryptocurrency, by volume, making a substantial contribution to trading volumes across all major exchanges. The current money velocity of USDT is around 57. Considering that real USD only has a money velocity of 4.4, it's apparent that USDT is changing hands in the marketplace at a frenetic pace.

If Tether disappeared from the marketplace due to a hack or lost its USD peg for various possible reasons, the results could be disastrous. If everyone tried to redeem Tether tokens for real USD, even if that were possible, there would most likely be a liquidity crunch where exchanges would be unable to fill sell orders as the price declines. With Tether now accepted on most major exchanges for a range of cryptocurrencies, “hodlers” and traders face the possibility of losing money in the event of a price crash.

Piecing together the Puzzle

All of the allegations against Tether and Bitfinex yet to have been proven with concrete evidence. Until Tether Limited can produce an independent third party audit, they will remain under suspicion with a large part of the crypto community. 2018 is shaping up to be another exciting year for Tether and Bitfinex. The results of the CTFC and SEC investigations and the ongoing audit saga combined with the popping of the Bitcoin price bubble are sure to keep crypto enthusiasts and investors glued to their newsfeeds. Trade and hedge accordingly.